There are a lot of options markets that are cash-settled. They are perceived by mkt participants as powerful and useful.
one of us is missing something here.... when it comes to cash settlement....lets work through a very simple example. expiry day 30th January at 4pm, price of the underlying stock is $1 If on the afternoon of the 30th January the price of the future is $1.50 at 3;59pm I sell the future at 1.50 to a person who buys it at 1.50.... you tell me - how is this settled? In my mind the 'tangible' thing 'to force the futures to trade with the underlying' is our separate bank accounts at the exchange. "all day ref"
There is nothing to force it to track the underyling. Prices move when people trade it and push prices up or down depending on buy or sell side imbalances. Arbitrage opportunities is what forces these separate markets to converge and track. If in your case, there is no physical settlement of the underlying, there is no tangible arbitrage opportunity. You say on Jan 30 you sell @ $1.5 while underlying is at $1. You are basically opening a short contract at $1.5. Say I buy at $1.5? I am opening a long contract at $1.5. Why cant we end the day in the futures exchange for that contract at $1.5? Basically you get settled $0 by the clearing firm, and I get settled $0 by the clearing firm. What is there to force that contract to be at $1? Nothing. Its a separate market. Its all fluff. There is no tangible thing to link the market anymore. Especially when liquidity dries up towards expiration. Contrast this with physically settled futures. You shorting futures at $1.5? You need to deliver the shares at $1.5 at the end of the day. Which means you would need to actually buy shares from the market or borrow shares to short. Me buying at $1.5? I simply wouldn't if its physically settled. I can buy the same 100 shares at $1.5 from the futures or $1 in the cash market. Of course I will go to cash market. Therefore, in this case, there is sell side imbalance, and your selling will help push the price towards $1. Hence why there is a huge difference between physically settled and cash settled futures.
You had best go back to Settlements 101..... EXPIRY day ---- SETTLEMENT will be at $1. Your account lost mine won - thanks. If you dont believe me try it. This is why people will do the arbitrage. That is what keeps it tending toward the spot price on the expiry day, and at or near 'fair value' throughout the contracts life. Liquidity might be another issue that causes prices to differ from FV. see you next expiry day
Quite frankly every major cash settled futures product that I am aware of is, in fact, heavily arbitraged against the analog underlying. Additionally, commercials and institutions actually prefer the cash settlement features in terms of dynamic hedging for their portfolios. It's a convenience for hedgers and they maintain BIG open interest in cash settled contracts like ES and GE.